“WHEN THE FACTS change, I change my mind. What do you do, sir?” Those words are sometimes attributed to Paul Samuelson, one of the the 20th century’s most influential economists. Due to a litany of cognitive biases—especially status quo and confirmation bias—letting go of cherished beliefs is easier said than done.
Which brings me to the topic of bonds and, more specifically, their role in the classic balanced portfolio of 60% stocks and 40% bonds. This mix is often the starting point for the moderate-risk investor seeking to balance risk and return. Since 1926, it’s generated an impressive 9.1% annualized return and has done so with far less volatility than an all-stock portfolio. Its worst year was 1931, when it fell 26.6%.
But one fact has changed over the past century, and it makes the historical record moot. Nominal interest rates are at rock-bottom levels—not just decade lows, but multi-century lows.
Bonds serve two primary roles in a portfolio: income and ballast. With bond yields near zero before inflation and deeply negative after inflation, income is not a great reason to hold bonds, perhaps with the exception of Series I savings bonds.
What about as ballast for a portfolio? A major appeal of bonds, particularly Treasurys and investment-grade bonds, is their relative price stability and the inverse correlation that bond prices often have with share prices. As I’m fond of saying, a bad year in the bond market can be matched or exceeded by a bad day in the stock market.
But investing is all about risk and return. With the 10-year Treasury yielding just 1.6%, is that measly return really worth the interest rate risk posed by potentially rising rates? In a 60-40 portfolio, a 1.6% bond yield contributes just 0.64% to the overall portfolio’s return, and that’s before taxes.
Furthermore, the great awakening of inflation could be a double whammy for bonds. First, real bond returns are reduced directly by inflation. Should the inflation rate persist at 6.8%, as it’s been over the past year, a 1.6% nominal yield equates to a real return of roughly -5%. Worse yet, if rising inflation leads to higher interest rates, bond investors would also suffer capital losses as the price of their bonds fall.
In short, traditional bonds may not protect investors as they have historically. A perfect storm of lower stock and bond prices is a real risk. What are the alternatives? While there are no perfect substitutes, here are some to consider:
1. Series I savings bonds and TIPS. Despite having negative yields to maturity, TIPS—Treasury Inflation-Protected Securities—do offer inflation protection. But they still carry interest rate risk, the risk they’ll fall in price if rates rise. That’s why I favor I bonds. Unfortunately, the amount of I bonds you can purchase is quite limited. Start buying some today.
2. Immediate fixed annuities. It may seem ironic that annuities would be a bond alternative, given that insurance companies invest annuity premiums primarily in… bonds. But the secret sauce of annuities is mortality credits—money left over from annuitants who die earlier than expected. This boosts the income that annuities can provide and, at the same time, reduces longevity risk in retirement. Unfortunately, inflation is a very real risk if you own income annuities. If possible, you may want to ladder your annuity purchases.
3. Cash investments or very short duration bonds. Despite some famous naysayers who have recently called cash “trash,” think of short duration bonds and cash investments as the ballast in your portfolio. Yes, they will lose you money after inflation. But holding a small portion of your portfolio in these investments can be extremely valuable when markets go haywire, as they do from time to time.
4. Precious metals. For the record, I’m not a gold bug. But as an inflation hedge, I have a small allocation to gold and gold-mining companies. Gold has been a store of value for thousands of years and I’m betting that it will remain so. I view my allocation to gold as an insurance policy. A 5% to 10% allocation seems reasonable given the unprecedented degree of monetary stimulus.
5. Cryptocurrencies. Just kidding. My apologies to crypto HODLers.
John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.